Business owners need to understand the tax implications of how they draw income from their businesses. This is a complex topic, but let’s start with a quick overview of options.
You have more freedom in deciding when you take distributions from the company with all of these options, but it also necessitates the need for careful tax planning.
Often business owners will pay quarterly tax estimates to avoid large balances due and/or underpayment penalties on their individual tax returns which occur if taxes are not paid in throughout the year. It is best if you have a personal tax planning strategy to help minimize your tax burden as much as possible.
There are three ways to receive payment from a corporation:
As a business owner in an S corporation, who is involved in the day-to-day operations, the IRS says you are required to take a salary and pay the required employment taxes on that salary. These taxes include FICA payroll taxes and federal unemployment taxes.
It might seem enticing to take a lesser salary to reduce the amount of employment taxation required, but the IRS has rules on how much corporate owners must be paid. According to the IRS Reasonable Compensation Guidelines, the key to establishing reasonable compensation is determining what the shareholder-employee did for the S corporation using these factors:
If you underpay yourself, you could face IRS fines. But if you overpay your salary, you may be paying more taxes than you need to. Be sure to review the IRS Reasonable Compensation Rules to guide you in determining your salary.
In an S corporation structure, you can also distribute profits from the business, which avoids employment taxation. S corporations are subject to single-level taxation. Income generated by the corporation is typically not taxed at the corporate level. It is distributed among the shareholders and reported on individual tax returns for payment of tax due on their share of the S corporation's earnings. Since an S corporation distributes income as single-level taxation, it will not be taxed a second time.
The taxable income earned by a C corporation is first taxed at the corporate level. When the income is distributed to its shareholders, it is generally taxed as a dividend. This results in the same income earned by the corporation being taxed twice (double taxation), once at the entity level and again at the shareholder level.
The tax implications noted above should be reviewed with your accountant as you determine if your business should be an S or C corporation. The double taxation noted above may not be as big of a concern now that there is a 21% flat income tax rate for C corporations. (Note the top individual income tax rate is currently 37%). S corporations may be able to take advantage of the Qualified Business Income (QBI) 20% deduction.
There may be a time when you want to take a loan from the company for a larger expense. If there is extra cash in the business, this can be a convenient option. However, it must be treated as a loan.
You will want to be sure the IRS won’t claim that the shareholder received a taxable dividend or compensation, rather than a loan. The IRS considers the following factors when deciding if it is a bona fide loan:
Flow-Through Entity or Sole Proprietorship | C Corporation |
One level of taxation: The business's income flows through to the owner(s). | Two levels of taxation: The business is taxed on income and then shareholders are taxed on any dividends they receive. |
Losses flow through to the owner(s). | Losses remain at the corporate level. |
The top individual tax rate is 37%, but for eligible taxpayers, up to 20% of qualified business income is deductible. | The flat corporate tax rate is 21% and the top rate on qualified dividends is 20%. |
The decision on how to pay yourself may change over the life of the business. Work with an experienced accounting firm to model out the option that affords you the best tax-advantaged way to draw your business income. This is not a one-and-done exercise. Compensation should be reviewed every couple of years to ensure the plan still fits your personal and business needs.